Square Inc.: Commoditized And Overpriced Product, Overloved And Overvalued Stock

| About: Square, Inc. (SQ)

Summary

Square – a mobile payment service provider, that also offers financial and marketing services – is severely overvalued.

With a market capitalization of $6.1 billion, the market is pricing in high margin revenue growth over an extended period.

Sell side analysts are largely bullish on this company with a “greenfield” growth opportunity.

We believe Square is likely to underwhelm investors – in a significant way – on both the revenue and margin front over the coming years.

We estimate a fair value of Square’s stock at $2.1 per share, which is roughly 90% below current market levels of $17.4.

Full report available here

Square (NYSE:SQ) is a Payment Service Provider.

At its core, Square provides a service that allows micro-merchants with low volumes of debit and credit card sales to obtain the benefits only a separate merchant account could otherwise have provided.

Square provides hardware and software to merchants that enable them to accept debit and credit card payments. The card readers and stands attach to smartphones and tablets, providing a business with a point of sale solution. We estimate a fair value of Square's stock at $2.1 per share, which is roughly 90% below current market levels of $17.4.

We believe Square is likely to underwhelm investors - in a significant way - on both the revenue and margin front over the coming years for the following reasons:

1. Square's customer base of financially disadvantaged and fickle micro-merchants is fundamentally unattractive: While most merchant acquirers seek financially strong and commercially thriving customers, Square targets exactly the opposite; desperate micro-merchants looking for a quick and easy payment processing solution with low up-front cost. Square attempts to onboard as many of these financially disadvantaged micro-merchants as possible to its overpriced payment processing platform - with free or highly subsidized debit and credit card readers - in the hope that a few successful micro-merchants will justify the acquisition costs of the millions of unsuccessful others. This strategy has worked to-date due to a first mover-advantage in micro-merchant payment processing and a conducive economic environment. Square's anomalously high transaction margins of over 1% and its string of surprisingly strong results over the last five quarters can be explained by these dual tailwinds.

Period ending

Actual Adjusted Revenue ($ million)

Consensus Adjusted Revenue ($ million)

Surprise (%)

Q4 2016

191.9

187.7

+2.2%

Q3 2016

177.8

172.9

+2.8%

Q2 2016

170.8

159.4

+7.2%

Q1 2016

146.2

134.6

+8.6%

Q4 2015

374.4

344.7

+8.6%

Source: Bloomberg, Author calculations

However, the hyperbolic growth Square has experienced over the last eight years is not sustainable. Square needs a constant influx of new micro-merchants to replenish its existing cohort of older micro-merchants, close to 70% of whom are at risk of leaving the platform at some point during their respectively business lifecycles.

The underlying dynamics of Square's business are ugly, characterized by an expensive mobile payment processing solution, a customer base with median card sales of just over $400 a month, high levels of merchant and GPV attrition - reaching 40% and 20% in a normal year, respectively - and potential recessionary merchant and GPV attrition rates, exceeding 50% and 40%, respectively. This dynamic will significantly dampen Square's Return on Invested Capital, compared to other payment service providers, such as PayPal and Heartland Payment Systems, who cater to a higher quality customer base.

2. Analysts comparing Square to PayPal or First Data are comparing "apples and oranges"; Square has more in common with Fitbit and GoPro: As a micro-merchant aggregator, Square's overpriced and commoditized product caters to a sub-prime customer base, has high transaction expenses, no moat, no network effects, no vertical integration, suffers from extreme competition and has almost zero switching costs. This contrasts with PayPal's payment processing platform that caters to a prime customer base, has a monopolistic presence as the internet's preeminent online wallet, a funding mix that frequently results in 100% margin transactions and high switching costs due to network effects developed from engaging both buyers and sellers.

Metric

PayPal

Square

Take-rate

2.65%

2.94%

Expense rate

0.95%

1.92%

Profit margin

1.70%

1.01%

Source: Square and PayPal Q3 2016 earnings, Author calculations

Fee

Visa Reg. Debit

Visa CPS / Small Ticket Credit

Visa CPS / Retail Credit

Interchange fee

0.05% + $0.22

1.65% + $0.04

1.51% + $0.10

Assessment fee

0.13% + $0.02

0.13% + $0.02

0.13% + $0.02

Processing fee

0.05%

0.05%

0.05%

Total transaction cost

0.23% + $0.24

1.83% + $0.06

1.69% + $0.12

Transaction cost as % of $15 sale

1.83%

2.23%

2.49%

Source: Visa, Author calculations

Square also stands in contrast to First Data - a vertically integrated merchant acquirer and payment processor - that earns abnormal profits due to low customer acquisition and payment processing costs.

Square has more in common with Fitbit and GoPro - pioneers in the connected fitness and action camera markets, respectively - that severely undershot lofty analyst projections because of the effects of brutal price competition in a commoditized low-barriers-to-entry business.

3. Extreme competition from ISOs/MSRs and traditional merchant acquirers will limit Square's growth and margins: A look at the micro-merchant mobile payment service provider landscape shows a bewildering number of Square competitors offering cheaper "no-frills" alternatives or similar polished products. Notable "no-frills" competitor Electronic Merchant Systems offers "EMS+", a service with a flat all-inclusive rate of 2.25% per swipe - compared to Square's 2.75% - and a free card reader.

Products with similar, and sometimes superior pricing, hardware and software to Square, include "Spark Pay" by Capital One, "QuickBooks GoPayment" by Intuit, "PayPal Here" by PayPal, "Clover" by First Data, and Pay Anywhere.

Traditional merchant account providers, which includes many Independent Sales Organizations (ISOs) and Member Service Providers (MSRs), now also offer mobile processing rates that make Square's rates look very high. First Data's Clover has been gaining market share with over 500,000 devices shipped and 16% market share amongst its SMB clients - establishing a strong presence in a Square target market.

There are also several new entrants. Chase Paymentech will soon be releasing a micro-merchant mobile payment processing solution with flat rates lower than Square's. Shopify has recently introduced a suite of POS products competing for micro- and small businesses. Verifone will soon be launching "Carbon", a payment terminal with a POS platform in a single device. And Poynt 5 and Poynt Smart Terminal are new open-architecture POS competitors to Square.

4. Square is over-earning; Gross margins will come down due to lower take-rates and stubbornly high transaction costs: Square's outsized gross margins are likely to come down substantially over time as it experiences pressure on take-rates from extreme competition and its efforts to move upmarket to merchants with higher GPV, all the while experiencing stubbornly high transaction costs, particularly high interchange and assessment fees. Analysts are extremely sanguine on these key drivers of Square's profitability - forecasting stability far into the future - despite several warning signs. PayPal's decline in take-rates and transaction margins over the last few years provides us with empirical evidence and a historical precedent, while Heartland's transaction profit margin a full fifty percent below Square's show us the real-world challenges of merchant acquirers moving up-market.

Metric

3/31/2014

6/30/2014

9/30/2014

12/31/2014

9/30/2014

6/30/2016

9/30/2016

12/31/2016

Quarterly GPV

53.676

56.736

58.184

66.039

58.184

86.208

87.403

99.4

Take-rate

3.11%

3.02%

3.01%

2.98%

3.01%

2.69%

2.65%

2.63

Transaction profit

2.15%

2.09%

2.09%

2.08%

2.09%

1.75%

1.70%

1.67%

Source: https://investor.paypal-corp.com/, Author calculations

Exhibit 13: Square's transaction profit margins are double Heartland's due to a focus on financially disadvantaged micro-merchants

Metric

Square

Heartland Payment Systems

Take rate

2.93%

2.30%

Expense rate

1.92%

1.80%

Transaction profit margin

1.01%

0.50%

Source: Heartland 10K, Square Q3 Shareholder letter

Interchange and assessment fees, which comprise over 80% of the cost of a typical transaction, are highly persistent as evidence from a Federal Reserve study over the last six years shows. In the card processing food chain, card networks - like Visa and MasterCard - call the shots. Square does not have the influence to maintain its high pricing structure or retain its successful clients.

5. Square has a limited Target Addressable Market in the U.S. and internationally: Square's over-bullish management team has misled the analyst community on the potential size of their TAM in the U.S., by repeatedly citing success with "large sellers" and U.S. card transaction volume of $10 trillion. The reality is that 99%+ of Square's customers, by number, are financially disadvantaged micro-merchants, with only a handful of SME customers. Square's prospects with large companies are extremely limited. For a business processing debit and credit card transactions with an average ticket size of $9 and monthly GPV greater than $7,700, leaving Square for a merchant account becomes economically preferable, due to special Visa/MasterCard small ticket rates. For businesses with higher average ticket sizes, the volume threshold is significantly lower due to the cap on debit card rates imposed by the Durbin Amendment. For example, for a merchant with an average ticket size of $30, the monthly GPV threshold to leave Square for a merchant account falls to $4,400.

Square's business model does not work as well in other developed markets, such as the U.K., Europe and Australia, and emerging markets, such as China and India. In the case of the U.K., Europe and Australia, consumer interchange fees are heavily regulated at very low flat rates between 0.2%-0.3%, so Square's all-inclusive flat payment processing fee is far less attractive to merchants. In the case of Emerging Markets, low levels of credit card penetration and prevalence of cash transactions for micropayments make Square's solutions significantly less attractive. In this respect, Square also faces regulatory risks that would potentially make its business model far less appealing for micro-merchants in the U.S. and Canada. A cap on credit card interchange fees, like debit card "swipe" fees implemented by the Durbin Amendment, could be potentially devastating to Square, yet is not a possibility being considered by analysts.

Square is also on the wrong side of a powerful technological megatrend towards digital payments and its hardware gateways risk obsolescence from larger innovative digitally focused payment solution providers, such as Apple, Google and PayPal, and even new tokenization technology such as that used by Apple Pay and Cartwheel Point of Sale. In fact, countries like China are leap-frogging debit and credit cards to move straight to online payment solutions like Alipay, WeChat Payment and Baidu Wallet.

6. Analysts are overestimating growth of Square Capital, which will likely experience a fate similar to other non-bank lenders, like OnDeck Capital: Square's core payment processing business lacks operating leverage, so - to justify lofty price targets - analysts are modeling rapid revenue and margin growth from upselling of Square's "value added services" - particularly Square Capital. Square Capital is an unattractive source of funding for all but the most desperate and financially disadvantaged micro-merchants given APRs in the region of 16%-28%. In addition to larger merchants, Square Capital also presents an economically inferior solution for successful micro-merchants compared to alternatives. SBA working capital loans - targeted at profitable and growing micro-merchants - have APRs a full 6% to 18% lower than Square Capital.

Square Capital is an attempt by management to stem the effects of GPV attrition due to successful micro-merchants leaving Square's overpriced payment processing platform for a more competitive solution. The decline of other non-bank online loan providers also reliant on fickle third-party funding sources, like OnDeck Capital, should serve as a cautionary tale for Square Capital.

7. Micro-merchants have neither the business need nor financial wherewithal to afford Square's "me-too" software products: Square's other "value added services" consist of "me-too" software solutions, such as Square Payroll and Invoice (à la Quickbooks), Employee Management (à la Zenefits), Cash (à la Venmo), Online Store (à la Shopify) and Appointments (à la Google Calendar). The median Square customer is a financially disadvantaged micro-merchant with approximately $400 of card sales that has neither the business need nor the financial wherewithal to purchase complex accounting, employee management, email marketing, and loyalty software. Given sales of Square's software are tied to the number of customers subscribing to it, not GPV volume, it is highly likely that software sales will undershoot analyst forecasts. Another indicator of the low demand Square's ancillary software is likely to generate is the lack of any mention of "ecosystem" by experts when comparing payment service providers.

Exhibit 21: Square's software products are expensive for the median Square micro-merchant with $5000 of annual card sales

Square software

Annual cost

Payroll subscription

$25 + $5 x 3 employees x 12 = $480

Employee Management subscription

$5 x 3 employees x 12 = $180

Appointments subscription

$50 per month X 12 = $600

Email Marketing subscription

$15 per month X 12 = $180

Loyalty subscription

$25 per month X 12 = $300

Gift cards purchase

$40 per pack X 2 = $80

Total

$1,820

Source: www.squareup.com, Author calculations

8. Unattractive industry economics and poor capital allocation decisions will detract from shareholder returns: Extreme competition and the fast pace of innovation in mobile hardware and software payment providers has led to unattractive industry economics with a need for extremely high R&D. In the twelve months ending September 30, 2016, Square devoted a full $263 million to product development, or 42% of adjusted revenues of $630 million. Given the lack of traction Square's "me-too" software products are likely to have with micro-merchants, we believe the return on this R&D will be poor.

Operating in a commoditized yet fast faced industry has led to high levels of capital expenditures (CAPEX), in the form of regular acquisition spending. For example, to get in-house access to the latest NFC/EMV technology for payment cards, in 2015 Square acquired Kili Technology- a fabless semiconductor company based in Canada. More recently, Square also bought a "software technology related to network connections" for an undisclosed amount. We believe such regular acquisitions, which highlight the elevated CAPEX needs of this business, will continue, negatively impacting shareholder returns.

Before focusing more exclusively on the current growth opportunity in micro-merchant card processing, CEO Jack Dorsey spent significant shareholder resources developing a failed food delivery business, first organically through Square Order, then through three acquisitions - Caviar in 2014 for $90 million, Fastbite in 2015 and Main Line Delivery in 2016. The returns on these investments have so far been poor, as these businesses continue to lose money. A "misfit" food delivery business shows a history of poor capital allocation. CEO Jack Dorsey is stretched thin, as he is also currently the CEO of Twitter, a company desperately trying to turnaround operations.

Staying true to its Silicon Valley roots, Square is a prolific issuer of stock for acquisitions and to employees as compensation, thereby diluting existing and future shareholders - if the practice continues. Over the twelve months ended 12/31/2016, Square issued $138.8 million of Stock Based Compensation (SBC), primarily to its engineering, design, and product personnel in product development ($91.4 million). This comes to 20% of the Company's Adjusted Revenue of $687MM over the same period. Given what we believe to be Square's limited prospects for profitable growth, we believe this generous SBC will detract from shareholder value. Using a dilution adjusted Black-Scholes model, we calculate the negative impact value on equity of outstanding stock options at the current stock price to be approximately $963.5 million.

Exhibit 24: Square's outstanding options are valued at almost $1 billion, based on a $17.43 stock price, and represent an overhang on the company's valuation

Current stock price

$17.43

Options Outstanding

86.7 million

Average Strike Price

$7.32

Average expiration term

7.4 years

Standard deviation of Square stock

43.5%

Risk free rate

2.4%

Value per option

$11.37

Valuation of outstanding options based on dilution adjusted Black-Scholes

$985.5 million

Source: Author calculations

9. The market is being too optimistic; Square's fair value is 80% below current levels: By valuing Square at $6.1 billion today, the market is implying a business that will grow revenues at close to 26% over the next ten years to over $7 billion, generate over $1.4 billion in operating income at margins close to 20% a year and generate ROICs close to 20% a year. This outcome is highly unlikely in our opinion given the realities of Square's customer base and business model.

Exhibit 25: Square - Combining reverse DCF with a customer dynamics model shows the market's implied steady state customer and revenue figures

Key metric

Market implied steady state

# of customers

19.3 million

Percentage of micro-merchant market

70%

GPV

$531 billion

% GPV > $500,000

14.7%

Transaction margin

1.04%

Square Capital origination volume

$9.1 billion

Square Capital "gain-on-sale" + interest revenues*

$548 million

Software subscription revenues

$269 million

Instant deposit revenues

$48 million

Invoice revenues

$48 million

Food delivery revenues

$122 million

Subscription and services-based revenue

$1,036 million

Square hardware revenue

$402 million

Total revenues

$7.0 billion

Operating income

$1.4 billion

Operating margin

20%

Return on invested capital

20%

Terminal cost of capital

8%

Source: Author assumptions

Under more realistic conditions, Square will likely see a sharp deceleration in revenue growth over time as the realities of its fickle and financially disadvantaged customer base become more apparent.

Our estimate of Square's long-term market share of the micro-merchant card payment processing market is approximately 7 million merchants, with strong competition from PayPal Here, Clover, QuickBooks GoPayment, Spark Pay, and Shopify.

Company

Percentage

# of customers in millions

Square

25%

6.88

PayPal Here

15%

4.13

Clover

15%

4.13

QuickBooks GoPayment

10%

2.75

Spark Pay by Capital One

5%

1.38

Shopify

5%

1.38

Chase Paymentech

2.5%

0.69

Pay Anywhere

2.5%

0.69

Verifone Carbon

2.5%

0.69

Poynt

2.5%

0.69

Others*

15%

4.13

Total

100%

27.50

* Others include "no-frills" solutions like EMS+ and Cartwheel Point of Sale, ISOs/MSRs like Flagship ROAMpay, National Bankcard and CreditCard Processing.com. Author estimates.

Exhibit 27: Projected Square revenues split between transaction, software and hardware revenues over the next 20 years

In a steady state, we believe Square will generate revenues of just over $2 billion, GAAP operating margins of 15%, Return on Invested Capital of 10%, with transaction margins close to 0.77% on a GPV of $171 billion. This compares to PayPal's revenues of $7.8 billion, GAAP operating margins of 20%, Return on Invested Capital of 9%, with transaction margins of 1.80% on a GPV of $354 billion.

Exhibit 28: Assumptions underlying DCF modeling

Key metric

Steady state assumption

PayPal TTM 2016

# of customers

6.9 million

197 million

GPV

$171 billion

$354 billion

% GPV > $500,000

14.6%

N/A

Transaction margin

0.77%

1.80%

Transaction revenues

$1.3 billion

$6.4 billion*

Square Capital Origination volume

$3 billion

$8.4 billion***

Square Capital "gain-on-sale" + interest revenues

$173 million**

N/A

Software subscription revenues

$85 million

N/A

Instant Deposit revenues

$17 million

N/A

Invoices revenues

$43 million

N/A

Food delivery revenues

$112 million

N/A

Total subscription and services-based revenues

$500 million

$1.352 billion

Square hardware revenue

$138 million

N/A

Total revenues

$2.1 billion

$7.8 billion

GAAP operating income

$315 million

$1.59 billion

Non-GAAP operating income

$420 million

$2.17 billion

GAAP operating margin

15%

20.5%

Non-GAAP operating margin

20%

28%

Return on invested capital

10%

8.8%

Initial Cost of Capital

10%

N/A

Terminal Cost of Capital

8%

N/A

Source: Author assumptions. * PayPal transaction revenues are calculated net of transaction costs. This results in a discrepancy between total revenues reported in 10-K (which are shown gross of transaction costs) and that shown in the table above. ** Assumes 6% revenues as % of loan size. *** 2015 origination volume. $7.4 billion PayPal Credit originations + $1 billion PayPal Working Capital originations

We estimate a fair value of Square's stock at $2.1 per share, which is roughly 90% below current market levels of $17.4.

Exhibit 29: Current price vs. estimated fair value of Square's common stock

Terminal cash flow (in millions)

$172.09

Terminal cost of capital

8.00%

Terminal value (in millions)

$3,071.05

Present Value of Terminal value (in millions)

$1,236.74

Present Value of Cash Flow over next 10 years (in millions)

$91.24

Sum of Present Values (in millions)

$1,327.98

Value of operating assets (in millions)

$1,327.98

- Debt (in millions)

$96.06

+ Cash (in millions)

$514.30

Value of equity (in millions)

$1,746.22

- Value of options (in millions)

$985.45

Value of equity in common stock (in millions)

$760.77

Number of shares (in millions)

366.59

Estimated value per share

$2.1

Source: Author calculations

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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